The Fed, along with other global central banks, has provided massive amounts of liquidity to markets since the onset of the global financial crisis “” liquidity which has worked its way through to various asset classes.

Perpetual Investments head of investment research Matthew Sherwood said that while stocks had gained aggressively over the past eight months, in part due to central-bank largesse, “all of a sudden” that pillar of market gains may be at risk.

This can’t be right, because economists assure us that QE has no effect. Bond prices rose on the news, as reported (or should I say “admitted”) in this WSJ article:

Treasurys pulled off minor gains after details from the Federal Reserve’s latest policy meeting initially caused some jitters about less bond-buying support from the central bank. . . .

After battling between gains and losses immediately following the release of the minutes, prices drifted higher as bond investors took comfort in the Fed’s presence. Benchmark 10-year notes rose 4/32 in price to yield 2.01%, according to Tradeweb. The 30-year bond gained 4/32 to yield 3.199%

I have a question for bond market aficionados; what does “took comfort” mean? And what does “Fed’s presence” mean? Why not just say; “Tighter than expected money lowered interest rates, just as Milton Friedman claimed.”

In fairness to the WSJ, things have improved dramatically since the dark days of 2001, when a much more expansionary than expected Fed announcement sent the S&P up 5% and long term bond prices crashed by more than 2%. The (1/4/01) WSJ explanation was laugh out loud funny. Here’s the headline and then the explanation:

. . . .Traded said the selling in bonds also reflected the fact that the market had been anticipating an easing of Fed policy soon and had already rallied on the expectation. When the Fed actually cut rates, people were, in bond market terms, “selling the fact.”

That had to be the explanation, because everyone was taught in school that easy money means lower interest rates.

Lots of people were excited when the Fed improved its communication last September, and even I called the move “baby steps” in the right direction. But there’s still far too much discretion, far too much room for mischief. If the Fed takes 1000 years to get unemployment down to 6.5% it will have fulfilled its promise not to raise rates until that target was reached (or until inflation rose above 2.5%.) But that’s still way too much discretion, and the wrong targets. They need a NGDP level target so that loose cannons within the Fed can’t roil the markets with reckless statements. There’s too much at stake. The Fed is gradually improving, but relative to where they need to be they are still just a bunch of children playing with matches.

The Fed tightened policy yesterday. Bernanke ought to be outraged by his colleagues.

This was a release of minutes from a month ago, correct? So this wasn’t your typical looose cannon, in that Bernanke and co. knew this was coming today. I wonder if if anyone at the Fed called this shot, privately, to their colleagues.

It’s still possible that low short rates may cause speculative bubbles. The opportunity cost of staying in safe assets has been raised tremendously. So it’s quite rational to join the speculative boom. So why call this speculative? Because it is subject to loose lips at the fed.

What do I mean by that… There may be a substantive difference between the threat of chuck Norris and the actual fight. What we have are low rates and no expectation of success.

In other words, the evidence of speculation is evidence that the market does not expect recovery, it does not expect higher rates soon, it expects perpetually low rates. I.e. failure, which makes the speculation rational.

As Rome burns, you know better than most how long change of this magnitude actually takes. It’s happening, though. Much has been written on NGDP (thanks to your herculian efforts) and just today Bloomberg offered, “Central Banks Discussed Nominal GDP Targets at G-20” http://bloom.bg/YD2im5 … curious why it took so long to get out in press … then again, I’m not at all. Change takes time. What they are doing (and by ‘they’ I refer specifically to the ‘hawks’ that don’t vote) is NOT good … coudn’t agree with you more, prof.

I’m pretty sure that “took comfort in the Fed’ presence” is a reference to the Fed buying bonds or, in other words, bond traders took comfort that the Fed is still present in the bond market purchasing bonds.

This is the problem with the Fed. Any improvement, no matter how minor, raises calls for tighter policy. If they keep doing this, then we will end up being Japan-lite (we have an effective inflation target of 1.5% versus Japan’s 0%).

“This can’t be right, because economists assure us that QE has no effect.”

I think the keynesian view is that it can have effect by inducing the public sector to engage in more spending. So in as far as there is a market reaction it can be due to a rise of expectations of further stimulus spending.

Of course in the same way the QE can induce reductions of future taxation. I think this argument breaks down in an economy where taxes are levied on unproductive, parasitic finance sector activities such that they are not a net negative thing.

My analogy would be not “children playing with matches” but that of a looser-ish day trader (which is to say a perfectly normail day trader:

10AM: “This is a great stock. I am going to plonk down 50% of my portfolio on it.”
12AM: “I am a freaking genius. Just watch this baby grow.”
2PM: “Sh1t… it’s down 10% on the day.”
3pm: “I should be patient and not be so quick to react. It’s just an abberation…. It’s just an aberration.”
3:59pm: “Sell! Sell! Sell! Sell!”

In other words, the people at the Fed are human and for some odd reason are sensitive to losses on their “investment portfolio” (I mean that literally – they are worried their Treasury investments will loose money!) They are so worried about this, you see, and would like to get the heck out of the position. Nevermind that the actual danger from the Fed loosing money is… I cannot actually understand what it is.

I for one would welcome the day when the Fed is taken over by a computer overlord that operates according to simple, algorithmic and predictable rules.

“I have a question for bond market aficionados; what does “took comfort” mean? And what does “Fed’s presence” mean? Why not just say; “Tighter than expected money lowered interest rates, just as Milton Friedman claimed.””

Because that wouldn’t be true. Bond prices ended the day at exactly the same price as before the minutes were released. Yes, up 4/23 on the day, but bonds were up 4/32 before the announcement, fell on the news and bounced back to the previous level quickly.

“This can’t be right, because economists assure us that QE has no effect.”

They’ll just say that QE is some sort of commitment device to enforce its forward guidance. The Fed is using QE order to convey its stern resolve to keep interest rates lower than they would otherwise be after the economy’s eventual recovery. If QE is reduced, the commitment device is weakened and the Fed is less likely to keep interest rates artificially low upon liftoff. Thus asset prices fell because expectations of higher rates increased.

“I have a question for bond market aficionados; what does “took comfort” mean? And what does “Fed’s presence” mean? Why not just say; “Tighter than expected money lowered interest rates, just as Milton Friedman claimed.””

This is exactly the explanation I use. Virtually no one has a coherent and complete theoretical framework in my experience…Frustrating to say the least.

I once left a comment to the extent that I get how bond buying can raise rates on bonds in theory but, as an empirical matter, it seems like I always read/hear the opposite in the news. I just wanted to say that after seeing your WSJ quotes in the right context, I think I get it. It’s amazing (frightening…) how pervasive and self-reinforcing a notion like tight money causes lower rates can be.

“Glad to hear you support a land value tax! Here’s a great recent post where Yglesias advocates taxing land values rather than…”

Land value tax is one of those idealistic economic reforms with grievous practical defects in application of the sort that idealists never consider, which make it disastrous in practice.

People with idealistic “new” tax schemes should always ask themselves this basic question before becoming too enamored of them:

Politicians tax *everything*, and I mean **everything** they can, often far too far to self-defeating excess. So if this tax is so hugely beneficial, easy to implement, and provides such big benefits that would give the community and its politicians a real competitive edge, then… why isn’t this tax already being used anywhere (or everywhere!) today?

The answer always is that the purported great “new” tax really is an old tax that was tried and abandoned for good reason.

The fact that Yglesias while endorsing land value tax is oblivious to both its long real world operational history and its fundamental defects that are obvious to any working tax professional … well, yet one more example of superficial idealism ignoring the lessons of experience and the laws of unintended consequences.

“Taxing A is bad, thus we should tax B” is highly illogical — it assumes that B can be effectively taxed.

It is effectively the same logical error as saying “Here is a market failure (A), thus we need government intervention (B)”. It **assumes** that B will make things better instead of even worse.

I’m not going to just take your word for it that land value taxes are not feasible. I suspect a major reason why we don’t have land value taxes is because……that’s where the money was. In the past, rich people owned tons and tons of land so they were probably very good at ensuring that taxes were levied elsewhere.

A second point is that finding comparable sales and making the appropriate valuation adjustments is way easier than ever due to technological progress. If the legal system is all f****d up and that’s a huge obstacle, then……reform the legal system.

Yglesias has another excellent post where he discussed land value taxes here:

“Their first objection is that doing assessments of land value ex structures accurately is difficult. That’s true, but doing the theoretically correct tax with some estimation error is much closer to optimal than doing the wrong tax accurately. Their third objection is the ridiculous one that a land tax will redistribute resources away from wealthy landowners, which they correctly note “might be viewed by some as a virtue rather than a fault.””

In my opinion, Prof. Sumner has not discussed the issue of central bank independence nearly enough. He’s suggested that the key thing we need to change is the consensus opinion of elite economists. But I don’t think that’s nearly adequate……

And there is a near religion in economics circles that central banks should be “independent.” It is a premise…

Now, I find the FOMC and the Fed are badly out of step with current day needs…independent public agencies necessarily ossify, and glorify their missions, and exalt their historic goals etc.

And we, as voters, can do nothing…it is worse in Europe.

But time now to shake it up…

Add on: The rate of inflation over the last five years is the lowest in 45 years….meaning that, in the midst of the worst economic downturn since the Great Depression, the Fed has obtained not higher than normal inflation,but much lower…..

Add on: With today’s CPI report, seven of the last nine CPI reports have been flat to down….

An independent Fed? Yes, they are free to suffocate us…..

And you still have caterwauling on the FOMC about inflation…..and bubbles….

Reminds me of the graph the other day showing markets are strongly correlated to Fed action now. That should tell people something.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.